Market experts believe that both fundamental and technical analysis can be combined effectively to give better results.
We look at both the approaches in this post, highlighting each technique's pros and cons.
What is fundamental analysis?
Fundamental analysis in forex trading considers factors, events, opinions, and policies that might affect a country's currency. Forex traders also consider factors that may affect currency values, such as interest rates, the overall economy of a particular country, and the government’s and central bank’s monetary and fiscal policies.
Events that have a negative effect on economies also tend to reduce the relative values of economies, while events that positively affect economies also increase the value of the related currencies. Drastic changes in political stability can also reduce economic activity, thereby affecting currency values. Another fundamental aspect of forex trading is understanding how other market participants like central banks, private banks, hedge funds, and other financial institutions affect the currency value.
Pros of fundamental analysis
Fundamental analysis can help explain price movements as major economic news and reports can change the direction of market prices. It also allows analysts to understand what is happening in a particular country’s economy and other economies worldwide. You also get an insight into global market conditions.
Fundamental analysis can help understand the discrepancy between an asset's true value and the trade market price. It considers factors like inflation, interest rates, industrial production, consumer sentiment, and others to find the right valuation. The real power of fundamental analysis is that helps a forex trader create a long-term view of a particular currency. The approach uses various economic data such as unemployment figures, job growth, and more to predict currency prices' potential impact.
Cons of fundamental analysis
Fundamental analysis is time-intensive as there is so much information available that it can get overwhelming for traders and investors. It is also not suited for short-term trades, and many fundamental traders focus more on long-term trade.
Fundamental analysis also does not provide a reliable way to time your entry and exit in the forex market. You may be headed in the right direction, but if your timing is wrong, you may end up incurring a loss. Fundamental analysts thus rely on other techniques to time their entry and exit into trading.
What is technical analysis?
Technical analysis tries to forecast future price movements through the mathematical analysis of historical price action. It involves the study of past forex prices to predict future trends and price movements and identifying opportunities for profitable forex trading. Technical traders believe that factors that can impact currency prices are already reflected in the current currency price.
Technical analysis uses various tools such as moving averages, trend lines, and support levels, relative strength index, Fibonacci studies, cycles, and so much more.
Pros of technical analysis
The most significant upside of technical analysis is that its helps traders and investors predict market trends. With chart analysis, it is easy to predict the uptrend, downtrend, and sideways movement of the market. It also helps predict the right time to enter or exit a trade resulting in profitable outcomes.
Technical analysis also gives early signals about the psychology of traders and investors regarding what they are doing. Price volume analysis can help predict market makers' movement and their activities related to a specific market. It is extremely helpful for short-term trading and swing trading.
Cons of technical analysis
One of the downsides of technical analysis is that there are so many technical analysis tools that sometimes they end up sending mixed signals. When such a situation arises, a trader must decide whether to take the trade or pass it based on the conflicting analysis.
Trading deals with probabilities and not certainties. There may be times when you may need to act on incomplete information. With so many technical tools available, many traders end up over-analyzing and not being able to make trading decisions.
The technical analysis depends on price as the main analysis tool, but certain biases may influence the way information is perceived from the charts. It is important to keep an open mind when analyzing charts.
Technical analysis, on some occasions, can also result in ambiguity. Two technical analysts may have different opinions and different conclusions about the same forex instrument using different techniques. Charts may also appear different at different time frames. Forming a single view using many analysis techniques, time frames, and indicators available is also a difficult task.
What is the difference between fundamental and technical analysis in forex trading?
Fundamental analysis takes into consideration the economic well-being of a country, and by extension, its currency. However, it does not consider the currency price movements. Forex traders that use fundamental analysis use data points to determine the strength of a country. They also analyze the country's inflation, the gross domestic product, trade balance, job growth in the country, and the central bank’s benchmark interest rates.
Technical analysis in forex trading involves identifying patterns on a price chart. Technical forex traders look for price patterns such as triangles, flags, and double bottoms, which helps them determine their entry and exit points. Technical forex traders evaluate the trends, price action, support, and resistance levels that can be observed on a chart. Many patterns that are used in the technical analysis of forex trading can be applied to other markets as well.
Technical analysis may be done through manual and automated systems. A manual system means that the trader analyzes the technical indicators and uses that data to make buy or sell decisions. Automatic trading analysis means that the trader is programming software to look for specific signals and interpret them to make buy or sell decisions. These automated systems may use historical price movements to determine the direction a country’s currency may be headed. Forex trading platforms like MT4 and MT5 offer traders wide technical analysis options for performing trading operations in the forex and exchange markets.
Why choose MT4 and MT5 for technical analysis?
MetaTrader 4 (MT4) offers a wide variety of inbuilt technical analysis tools. It comes with 30 built-in indicators, more than 2,000 free custom indicators, and 700 paid ones. It allows you to analyze the market of any complexity level. MT4 offers 24 analytical objects: lines, channels, the Gann and Fibonacci tools, shapes, and arrows.
MetaTrader 5 (MT5) offers traders an elaborate set of tools for comprehensive technical analysis. MT5 offers 44 analytical objects, along with Gann, Fibonacci, and Elliott tools, geometric shapes, various channels, and more. Unlike the technical indicators, the analytical objects must be applied manually.
Both MT4 and MT5 are powerful technical analysis tools that can help traders make informed decisions. These tools help forecast future price dynamics, price direction and help detect various trends and patterns.
Fundamental vs. technical analysis: Which is better?
Proponents of both techniques often downplay the other, but they both have their own distinct place. Traders can combine both fundamental and technical analysis to plan and execute medium and long-term investment strategies.
Fundamental analysis looks at the forex market by analyzing economic, social, and political events that may affect currency prices. It helps you understand why and how some events such as an increase in the unemployment rate affect a country’s economy and fiscal policies, which ultimately affect the demand level for its currency.
When it comes to the global forex market, currency buyers and sellers determine one forex instrument's rates versus others on a real-time basis. At the same time, the level of currency volatility is monitored by various governments to maintain stability. Technical analysis can be very useful in the currency markets as it can provide clues about levels where the government is likely to intervene.
Both fundamental and technical analysis use very different strategies as well as different approaches to trading. Each technique offers unique insights and value to support trading decisions. To sum up, fundamental analysis is a long-term approach and helps explain why there is a price movement. Technical analysis helps answer the “when” as it determines accurate entry and exit points in forex trading. While some may want to pick one approach over the other, blending the two approaches helps you take advantage of both.